Is Now the Time to Buy Covered Call ETFs?

Covered call exchange traded funds (ETFs) are one tool in investors’ tool kit to try to maximize returns during what investors see as potentially sideways markets for a period of time. Given the run the stock market has had over the past two years, and where valuations are right now, earning some extra yield from funds that sell calls on their portfolio holdings may make sense. 

Covered call ETFs essentially provide investors with exposure to a portfolio of stocks, selling calls on the fund’s core holdings to generate yield. If the stocks within such a portfolio surge higher than the exercise price (the contractual price agreed upon in the call contract, same goes for puts), that position is “called away” and the fund will need to re-purchase that particular holding at a higher price, buying calls again at some level that’s higher than where the stock is trading at the time of purchase.

Let’s dive into what such a strategy may mean for investors, and if now is the right time to implement such a strategy in an investment portfolio. 

The Bull Case

The famous Wall Street bull running through the street

As mentioned, investors who think the market is likely to stay steady or decline slightly over the near-term may outperform the market by buying covered call funds. The extra yield such funds can generate from selling calls can, in some cases, more than offset the losses the market may provide over a period of time. So, for those who believe a period of stagnation (or stagflation) is ahead, such a strategy could indeed turn out to be a winning strategy. 

Additionally, the premium an investor (or an ETF in this example) receives from the market increases during times of volatility. Thus, if investors expect the implied volatility rate in the market at a given point will ultimately decline, it’s possible to take advantage of that extra premium in the near-term by buying such funds.

Other options such as put selling ETFs are also available, for investors looking to pick up stocks at a cheaper willing (in other words, those not willing to pay today’s prices for stocks) while receiving income in the near-term. 

Furthermore, buying such covered call ETFs can provide some risk mitigation for investors who may feel they’re overly-exposed to equities in what could be a more muted return environment. Instead of selling calls directly or hedging one’s portfolio actively, these funds provide a passive way to do so. 

And with some of the best tax efficiency and accessibility out there, this is a strategy that’s started to garner more attention of late.

The Bearish Case

Bear market visual

Now, there are some key downsides to investing in such covered call strategies that investors ought to be aware of. Indeed, investors who bought such funds in 2022 during the last major dip in the market would have been much worse off than those that simply stayed exposed to the market. That’s because as positions get called away in a covered call fund, there are costs associated with repurchasing those positions. And the upside investors would have received (over and above the exercise price of the call options) will be given up.

Thus, investors will want to know how aggressively (or conservatively) a covered call fund sets its exercise prices across the board. The ultimate determination of how flat or down an investor expects the market to be over a given time will play into the analysis as to whether such a fund is a good investment. But for those who think that over the near to medium term the market could produce near-average returns, such a strategy is one most financial advisors would warn against.

There’s also added complexity with putting such a strategy in place in a given portfolio. Investors may lack transparency on how a given covered call ETF executes its strategy. And to me, this is among the biggest sticking points, aside from the potential tax implications of putting such a strategy in place.

So, Are Covered Call ETFs Worth It?

A man putting his hands in the air

I think the answer to this question really comes down to an individual investor’s expectation of market returns over a given period of time. This year, returns have been muted, and the market did see a volatility-driven drop during the second quarter tied to tariff concerns. If we see such concerns materialize again (and it looks like tariff talk is picking up in recent days), then such a strategy may work out. 

But for those with a meaningfully long investing time horizon, I think such ETFs aren’t worth it. Capping one’s upside on a market that can surge well in excess of 10% per year during bull markets (for a few percentage points of yield) doesn’t make sense.

In my personal portfolio, I don’t own any such funds. But in today’s market environment, I can also understand why some investors may be compelled to purchase such securities. 

I’d just say do your homework before diving in. These investment vehicles can be more complex than many think and will carry more risk.